Red flags of peer-to-peer lending

Peer-to-peer (P2P) lending emerged in the early 2000s as an alternative option, allowing people to borrow from other individuals rather than from banks or financial institutions. Today, there are more regulations on these types of loans than there were in the beginning, but there are still questions about the best ways to protect both lenders and borrowers from these types of loans.

Despite regulatory discussions, a direct Internet connection to a group of lenders willing to back all or part of a loan can be a useful alternative to more traditional lenders. Additionally, it offers a potential opportunity for individual lenders, also known as investors, to make extra money.

However, not all peer-to-peer lenders are equal, and the burden of due diligence falls squarely on the shoulders of potential borrowers and lenders. That’s why it’s important to watch for potential red flags, such as additional fees, higher interest rates, and a lack of FDIC insurance.

Red flags in peer-to-peer lending for borrowers

Borrowers may find P2P lending a good option if they are low on cash, but a more extensive vetting process should take place before applying for a P2P loan. To reduce the risk of longer-term financial damage, borrowers should ensure they use a reputable lending platform and have a plan in place if they encounter any of these red flags.

Borrowers may have to pay additional costs

“If you’re fed up with bank fees, you’ll really hate P2P lending,” says Howard Dvorkin, CPA and president of Debt.com. “On top of the interest you pay, there are origination fees, which can be as low as 1 percent but as high as 8 percent. That is much more than a bank or credit union will charge you for a personal loan.”

Traditional personal loans can come with late fees, origination fees, prepayment penalties, non-sufficient fund fees, and processing fees. Although each fee is often on the lower amount (for example, late fees are often $39), they add up over time. And if you have lower credit, the costs will often be even higher, on top of the higher rates.

That said, P2P loans charge high origination fees and can charge fees similar to personal loans. Before applying for a P2P loan, read the terms and conditions to ensure you are aware of all fees charged and be on the lookout for hidden fees.

Borrowers can get worse rates than on traditional loans

P2P lending can sometimes have lower rates than traditional lending, but borrowers should investigate this. You can often get comparable or lower rates from a traditional credit institution.

Dvorkin says it can be difficult to determine whether interest rates will be lower because P2P lending is often marketed with lower interest rates than traditional lenders. “But it’s actually hard to say. Is a particular P2P loan really cheaper than your credit union if you have a decent credit score? Especially after you factor in the costs? There is no easy answer.”

Before you apply, crunch the numbers and consider all your credit options to ensure you get the best rate for your credit score. For example, research interest rates at local lending institutions, such as banks, credit unions and online lenders. Often online lenders offer the lowest interest rates, with some offering loans to individuals with lower credit scores.

Less support if there are problems paying the loan

If a borrower is unable to repay a loan within the agreed terms, lenders have the right to take legal action to settle the arrears. A traditional bank can provide support, such as a payment plan or a longer period to repay the loan before a loan goes to collections. However, peer-to-peer lenders can send a defaulted loan to a collection agency within 30 days.

If your payments are late, a P2P lender may increase interest or add fees. If you plan to borrow with a P2P loan, make sure you know the terms you are signing up for. A traditional lender might be more lenient with an unpaid loan, but a P2P lender is likely to take quicker action against a defaulting borrower.

Red flags in peer-to-peer lending for lenders

Like most investment opportunities, lenders (or investors) face potential dangers with peer-to-peer lending. If you’re interested in becoming a P2P lending investor, you can get a significant return on your investment, but you also need to understand the risks you face when becoming a lender.

If the borrower defaults, lenders often lose their money

Although some peer-to-peer loans are secured, they are usually unsecured loans. This means that the borrower does not borrow against any collateral, and if he cannot pay his loan, the lender loses his money. The money that the borrower has not repaid is lost. Although the balance can be sent to collections and prosecuted in court, property or assets cannot be seized to repay the remaining loan funds.

Loans are generally not FDIC insured

The Federal Deposit Insurance Company (FDIC) is an agency established by Congress to protect and insure financial transactions in the United States. A loan from a traditional bank is FDIC insured, but many P2P loans are not. Unless the funds are deposited at an FDIC-insured bank, a P2P loan may not have this extra layer of protection.

This means that lenders are not guaranteed that they will see their borrowed money back as with other deposits or investment options. However, there is a potential for positive monetary gains by investing in a P2P loan, although the risks may be higher compared to other investment options.

The return may be lower for the lender if the borrower pays early

As the borrower pays the loan, the lender gets his money back. While this may seem positive, it means that the loan funds will no longer earn interest. If the borrower pays the loan early, you will get your original investment back into your account, but the return will ultimately be lower.

Before investing in a P2P loan, make a plan to combat the potential for low returns by reinvesting the money paid. If the balances are paid back, this way you can minimize your negative returns.

Why do some people want peer-to-peer lending?

Both borrowers and lenders want to try peer-to-peer lending for many reasons. First, P2P lending often offers lower interest rates for borrowers with good credit scores than traditional lending intuitions.

That said, if borrowers don’t have sufficient credit, P2P lending can allow them to get a loan when a bank may not approve it.

Lenders of P2P lending may be enticed by the high returns they can achieve compared to other investment options. Typical returns for P2P investors per year average approx 5 percent to 9 percent while some investors see it 10 percent or more gives back.

it comes down to

P2P lending can be a great option for both borrowers and lenders, but both should carefully weigh the pros and cons when deciding whether this type of lending is right for them.

Borrowers should beware of additional fees or rates that are similar to those of other lenders. P2P investors must be aware of the financial risks they are taking and understand the returns they can achieve compared to other investments.